Wall St. and Business Wednesdays: E-Letter To Christopher Farrell and BusinessWeek Re: "A Housing Boom Built on Folly"

Last year around this time, while serving as strategist to her eventually successful congressional campaign, Cynthia McKinney called me prior to a candidate screening she was to participate in, before an important association of real estate professionals and institutions. We had a conversation regarding the issues that they championed and were concerned about. The subject of capital gains was an area in which they were interested in learning her position. I advised Ms. McKinney that she express support for the position that capital gains on the sale of a home be exempt from taxation, but that she articulate her view that there are too many Americans and those in the Fourth Congressional District of Georgia who do not even have the opportunity to own a home to sell. In addition to this, the impact that foreclosures and bankruptcies were having on homeownership in Atlanta and DeKalb County was an area we agreed she should highlight, all as part of her documented and consistent commitment to the issue of homeownership, while a sitting member of Congress and as a citizen. We concluded our conversation and I e-mailed her a suggested statement.

Ms. McKinney called me shortly after the screening to tell me how well it went and how particularly pleased they were with her answer regarding capital gains tax treatment. Judging from her reaction, it appeared that some present during the screening were pleasantly surprised by her stance. It confirmed some things for me.

That experience came to mind when, with great interest, I read your recent article, "A Housing Boom Built On Folly". Although I think you have arrived at an important insight regarding a fundamental relationship between taxes and investment, your broad stroke analysis of the housing market and how it and the economy are supposedly adversely affected by the treatment of capital gains, indicates that perhaps your article is more affected by ideology than a search for the facts, accurate interpretations, and a real prescription to a potential problem.

The ideological premise that I believe you reveal midway through the article is, "As much as possible, the tax code shouldn't bias investment decisions." I have heard this argument from self-styled or supposed purists on both the political right and left and I am never able to follow the logic of it nor do I ever fail to find hypocrisy or inconsistencies in how they apply this standard. Just on the surface, the position can't be taken seriously, as every economy in the world has priorities or a bias toward who, what, where, when, and how it will invest the resources of its nation. And the tax code (or lack thereof) is always the arbiter of the wealth distribution. Not knowing you, I am only prepared to depict your use of this 'maxim' as naďve or uninformed at worst.

As a Black publisher, political strategist and economist, I tend to challenge such ‘rules’ by applying them to the Black economy. Usually that is enough to expose some fallacious reasoning. Certainly in light of the history of Black Americans in this country, it is usually relatively easy to establish that there has not ever existed a level playing field in terms of wealth and income between Whites and Blacks. And as a result we have had a running debate, tensions and an entire industry that has developed around the issue of how to solve this problem. It is not serious to believe that disparities in wealth, in particular, can ever be solved by adherence to your premise, "As much as possible, the tax code shouldn’t bias investment decisions."

Now a great many people in this country, in open discussion at least, would probably state that they believe that increasing Black homeownership, and closing a racial disparity in that area, in light of the history of this country, is a good thing. Certainly President George W. Bush is one such person, regardless to his motivation(s). Well, can this really be done unless the tax code contains a bias toward certain investment decisions? Your narrow focus on a supposed principle and your concerns about excessive investment in housing as opposed to other sectors of the economy, (among other potential factors) probably contributes to your lack of consideration to how Black America is affected by the bias toward investment decisions contained within the tax code.

Your distaste for what President Clinton’s 1997 Taxpayer Relief Act has meant for homeowners is not only not shared by supply-siders; but I am very confident that it is not shared by an untold number of Black Americans (and others) who, over the last decade, have been able to accumulate wealth, supplement income and start businesses as a result of their ability to profit from their purchase and sale of a home.

The law and its affect (which you properly describe as: "Under a set of easily met limitations -- mainly that a home has been a primary residence for two out of the past five years -- a family can exempt the first $500,000 in profit on the sale of the home from capital-gains taxes. The comparable figure for a single filer is $250,000.") has been a boon for Blacks, as first-time homeowners, investors, speculators, realtors, bankers and financial consultants. As a friend of mine who invests in homes told me yesterday, buying a home and receiving the benefit of its appreciation is "a way to come up."

Compared to prior circumstances what new wealth-creating ground did the 1997 law break for homeowners?

"...May 7, 1997, the only way you could avoid paying taxes on your home-sale profit was to use the money to buy another, more-expensive house within two years. Sellers age 55 or older had one other option. They could take a once-in-a-lifetime tax exemption of up to $125,000 in profits. And in all instances, there was tax paperwork (Form 2119) to fill out to show that you followed the rules.

But when the Taxpayer Relief Act of 1997 became law, the home-sale tax burden eased for millions of residential taxpayers."

In order to understand the context in which President Clinton’s signature of the 1997 Taxpayer Relief Act and President Bush’s continued emphasis on minority homeownership have appeared and combined to result in wealth creation for many in Black America; it is important to consider history and factors broader than the tax code.

Although economic historians and labor economists have long been interested in the historical evolution of racial differences in income and education, less attention has been paid to other types of racial differences in economic status, including housing. We study housing because, in the United States, racial gaps in wealth are much larger than racial differences in income. Although racial gaps exist across all types of assets, those related to housing are particularly salient, because housing equity is a major component of household wealth and African-Americans hold a relatively higher proportion of wealth in owner-occupied housing. Housing is also a major component of private consumption, and housing values reflect both the housing services embodied in the housing unit and access to transportation, employment, retail establishments, security, and various public goods.

Collins and I have written several papers about the long-run evolution of racial differences in housing, all of which drew in one way or another on the public use samples of the U.S. census. In one paper,(4) we studied secular trends in racial differences in home ownership. African-Americans emerged from slavery with little or no physical wealth but, by 1900, nearly 22 percent of African-American male household heads owned their homes. Considering the initial condition -- near zero wealth in 1870 -- this is an impressive accomplishment. But the rate of black home ownership fell far below that of white household heads at the time -- 46 percent -- implying a racial gap of 24 percentage points. Still, if we control for various correlates of home ownership, such as the age of the household head, literacy and occupational status, and location, then the "unexplained" portion of the racial gap declines to 15 percentage points.

Over the next 40 years there was little overall change in either the black or white homeownership rate and, consequently, in the racial gap. For blacks, homeownership rates did rise during the first decade of the twentieth century, but they fell between 1910 and 1920. The relevant correlate here was the "Great Migration" from the rural South to the urban North; blacks (and whites) living in central cities were far less likely to be homeowners than those living elsewhere. Black homeownership continued to slide between 1920 and 1940, largely because of declines during the Great Depression of the 1930s.

In 1940, the eve of World War II, slightly more than 20 percent of black male household heads were homeowners, compared with 42 percent of white male household heads. The ensuing two decades would witness a vast transformation in American housing, one in which homeownership rates rose substantially for both races. But the gains were larger in absolute terms for whites than for blacks. In 1960, the black homeownership rate stood at 39 percent, while that for whites was 66 percent, implying a larger racial gap. However, if we control for the correlates of homeownership, then the unexplained gap is about the same as in 1940 (or in 1900). Again, the culprit was migration north: migrants were less likely to be homeowners, particularly those migrating to central cities.

In the period since 1960, the racial gap in homeownership among male household heads has narrowed. In 1990, the last year examined in this paper, the racial gap was 19.5 percentage points, compared with 27 points in 1960. Because white homeownership rates were rising over this period, all of the narrowing of the gap reflects a faster pace of growth among black household heads. Moreover, when we control for the correlates of homeownership, the unexplained racial gap fell sharply from 1960 to 1990.

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Since 1990, and particularly the last 10 years, Black homeownership has hit record highs and the racial disparity - in this area - between Black and White Americans, has closed at an accelerated rate. In my view, in addition to the positive benefits of political manipulation of the tax code, there was a confluence of forces that combined to produce this result but the six major factors were: 1) increased income levels among Blacks 2) increased wealth accumulation due to investment in the stock market 3)increased incentives for first-time home ownership 4) increased networking in the Black community around wealth creation through real estate related activities 5) increased Black migration from the North to the South (away from apartment rentals to where property values and economic opportunity were favorable) and 6) relatively low interest rates.

The result has been a cultural and economic value system that contributes to homeownership, among Blacks, as never before.

If the capital gains tax treatment for homeownership of the 1997 Taxpayer Relief Act were to be eliminated and a capital gains tax of 15% established, as you suggest, you would immediately see what you say you fear, a collapse of the housing market. And guess who would be hurt the most? Yes, those most recently entered into the market and those disproportionately looking forward to investment income from the sale of a home.

Black Americans would be at the top of both lists.

In order to give you an idea of how important homeownership and the capital gains on the sale of a home have been for Blacks, you should consider the experience and data of the last five to six years regarding Blacks tenuous engagement with the stock market. In 2003 an Ariel-Schwab survey revealed that 76% of Blacks surveyed viewed investments in home improvement as preferable to stocks. This was 15% higher than the view held by Whites. Interestingly over the last few years Whites have increasingly indicated their preference for investing in real estate as opposed to the stock market. But what makes housing such an important investment and form of wealth maintenance and accumulation for Blacks is the relatively few forms of other assets that they own and the role real estate can play as a hedge against economic misfortune. During the recent recession, home ownership was particularly important for said individuals. As the stock market fell and jobs were lost, real estate values continued to move higher.

I do recognize that much of the gains from investment in real estate reaped by Blacks have gone toward conspicuous consumption. And I am also aware that corruption and excessive speculation in property investment and within the mortgage business is dashing the hopes and fortunes of prospective and real Black homebuyers and investors.

But what your article shows, perhaps unintentionally, is that the tax code’s bias toward certain investments works, and sparks economic growth in specific areas. It is a position that I have maintained for years when suggesting to ideologues and purists, how Black wealth creation and entrepreneurship (and as a result the entire Black economy) stands to benefit by more sophisticated targeted treatment of capital gains and income by the tax code.

It is an under explored arena of both economics and American politics.

I hope that you will continue to write on this subject but from a much broader perspective.

P.S. I think I may have a red flag for you regarding a housing market 'bubble' more credible than the 1997 Taxpayer Relief Act. After writing this to you I watched "Street Signs With Ron Insana", on CNBC. The topic was the "Rolling Boom" in the housing market. Mr. Insana interviewed two guests: David Lereah, Chief Economist of the National Association Of Realtors and Robert Schiller, noted author and economist. It was Mr. Lereah's remarks that got my attention. He said that we are now experiencing a "rolling boom" or "rolling effect" in the housing market whereby parts of the housing market that were once hot are now cooling off a bit and actually expanding into nearby areas. He gave two examples of this - the hot D.C. area market which is now cooling off a bit and causing investors to look increasingly at nearby Baltimore. And the exceeedingly hot Las Vegas housing market is cooling down a bit (expected to go from 52% annual growth to 12%) with investors looking away from Vegas and toward Reno, Nevada.

After this explanation, Mr. Insana then hit Mr. Lereah with a great question about an article in today's (Tuesday, August 16, 2005) Wall St. Journal, "Alternative Mortgages Increase But Still Trail Traditional Loans". This article talks about the increase in popularity of alternative mortgages which are interest-only loans and option-adjustable mortgages that carry introductory rates as low as 1% and give borrowers multiple payment choices. According to the Wall St. Journal these loans have the Fed, the Federal Deposit Insurance Corp. and the Treasury Department's Office of the Comptroller of the Currency and Office of Thrift Supervision all worried because they indicate a loosening of lending standards. These loans were previously the domain of elite borrowers and now are increasingly being marketed on a mass level to bank customers and home owners.

David Lereah, in response to Mr. Insana's raising of the issue said that there is cause for concern regarding these types of loans, as they set borrowers up for "payment shock" when interest rates go up (and the Federal Reserve continues to raise them)but at present because there is no high concentration of these types of loans in any one area of the country, he is not too worried.

So instead of focusing on the tax code's treatment of capital gains, you may want to keep one eye on banks and their level of concentration in alternative mortgages in say, the Atlanta, New York, Baltimore, Phoenix, and Miami markets; and the other eye on Federal Reserve monetary policy.